Inverted Yield Curve and How It Predicts a Recession

Pay Attention When the Yield Curve Inverts

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An inverted yield curve is when the yields on bonds with a shorter duration are higher than the yields on bonds that have a longer duration. They are abnormal.

In a normal yield curve, the short-term bills yield less than the long-term bonds. Investors expect a lower return when their money is tied up for a shorter period. They require a higher yield to give them more return on a long-term investment.

When a yield curve inverts, it's because investors have little confidence in the near-term economy. They are demanding more yield for a short-term investment than for a long-term one. They would prefer to buy long-term bonds and tie up their money for 10 years even though they receive lower yields.They would only do this if they think the economy is getting worse in the near-term. An inverted curve often predicts a recession.

What an Inverted Yield Curve Means

An inverted yield curve is most obvious with Treasury note yields. That's when yields on one-month, six-month, or one-year Treasury bills are higher than yields on 10-year or 30-year Treasury bonds. During healthy economic growth, the yield on a 30-year bond will be three points higher than a three-month bill.

An inverted yield curve means investors believe they will make more by holding onto the longer-term bond than if they bought a short-term Treasury bill.

They'd just have to turn around and reinvest that money in another bill. If they believe a recession is coming, they expect the value of the short-term bills to plummet sometime in the next year. They know that the Federal Reserve lowers the fed funds rate when economic growth slows. Short-term Treasury bill yields track the fed funds rate.

So why does the yield curve invert? As investors flock to long-term Treasury bonds, the yield on those bonds fall. They are in demand, so they don't need as high a yield to attract investors. The demand for short-term Treasury bills falls. They need to pay a higher yield to attract investors. Eventually, the yield on short-term bills rises higher than the yield on long-term bonds and the yield curve inverts.

 Recessions last 18 months on average. If investors believe a recession is imminent, they'll want a safe investment for two years. They'll avoid any Treasurys less than two years. That sends demand for those bills down, sending yields up, and inverting the curve.

When the Inverted Yield Curve Last Forecasted a Recession

The Treasury yield curve inverted before the recessions of 2000, 1991, and 1981.

The yield curve also predicted the 2008 financial crisis two years earlier. The first inversion occurred on December 22, 2005. The Fed, worried about an asset bubble in the housing market, had been raising the fed funds rate since June 2004. By December, it was 4.25 percent.

That pushed the yield on the two-year Treasury bill to 4.40 percent. But the yield on the seven-year Treasury note didn't rise as fast, hitting only 4.39 percent.

That meant investors were willing to accept a lower return for lending their money for seven years than for two years. That was the first inversion.

By December 30, the discrepancy was worse. The two-year Treasury bill returned 4.41 percent, but the seven-year note yield fell to 4.36 percent. The 10-year Treasury note yield dropped to 4.39 percent, below the yield for the two-year bill.

A month later, on January 31, 2000, the Fed had raised the fed funds rate. The two-year bill yield rose to 4.54 percent. But that was more than the seven-year yield of 4.49 percent. Yet the Fed kept raising rates, hitting 5.25 percent in June 2006. The fed funds rate history can give you an insight on how the Federal Reserve has managed inflation and recession throughout the years.

On July 17, 2006, the inversion worsened again when the 10-year note yielded 5.07 percent, less than the three-month bill at 5.11 percent.

This showed that investors thought the Fed was headed in the wrong direction. The article, “Subprime Mortgage Crisis: Its Timeline and Effect.” describes how defaults on these mortgages caused the 2007 banking crisis, which led to the 2008 financial crisis and the worst recession since the Great Depression.

Date Fed Funds  3-Mo  2-Yr  7-Yr  10-Yr 
Dec. 22, 2005       4.25 3.98 4.40 4.39 4.44
Dec. 30, 2005      4.25 4.09 4.41 4.36 4.39
Jan. 31, 2006      4.50 4.47 4.54 4.49 4.53
Jul. 17, 2006      5.25 5.11 5.12 5.04 5.07

Unfortunately, the Fed ignored the warning. It thought that as long as long-term yields were low they would provide enough liquidity in the economy to prevent a recession. The Fed was wrong.

The yield curve stayed inverted until June 2007. Throughout the summer, it flip-flopped back and forth, between an inverted and flat yield curve. By September 2007, the Fed finally became concerned. It lowered the fed funds rate to 4.75 percent. It was a 1/2 point, which was a significant drop. The Fed meant to send an aggressive signal to the markets. 

The Fed continued to lower the rate 10 times until it reached zero by the end of 2008. The yield curve was no longer inverted, but it was too late. The economy had entered the worst recession since the Great Depression. The current fed funds rate determines the outlook of the U.S. economy. Word to the wise: Never ignore an inverted yield curve.